Ultramares Case Establishes Liability for Auditors

Date 1931

The 1931 New York case of Ultramares Corporation v. Touche set a precedent in establishing auditor liability to third-party users of audited financial statements.

Locale New York, New York

Key Figures

• Benjamin N. Cardozo (1870-1938), chief justice of the Upper New York Court of Appeals
• George A. Touche (1861-1935), founder and partner of Touche, Niven, and Company
• John Ballantine Niven (1871-1954), founding partner of Touche, Niven, and Company

Summary of Event

The 1931 court case Ultramares Corporation v. Touche set a precedent in establishing auditor liability to third parties. The case established that auditors were not liable to “unknown” third-party users of financial statements for ordinary negligence. The New York Court of Appeals held, however, that auditors could be liable to “known” third parties for ordinary and gross negligence and liable to “unknown” third parties for gross negligence when the negligence equated with “constructive” fraud.

In January, 1924, Fred Stern and Company hired a public accounting firm, Touche, Niven, and Company (founded by George A. Touche and John Ballantine Niven), to audit its balance sheet for December 31, 1923. Touche performed the audit and rendered a “clean” opinion. Touche, Niven, and Company attached to the balance sheet a certificate dated February 26, 1924, that read as follows:

We have examined the accounts of Fred Stern & Co., Inc., for the year ending December 31, 1923, and hereby certify that the annexed balance sheet is in accordance therewith and with the information and explanations given us. We further certify that, subject to provision for federal taxes on income, the said statement, in our opinion, presents a true and correct view of the financial condition of Fred Stern & Co., Inc., as at December 31, 1923.

After the opinion by Touche was rendered, Stern presented the balance sheet and certificate in its financial dealings. The balance sheet indicated assets of $2,550,671, liabilities of $1,479,956, and net worth of $1,070,715. In reality, the corporation was insolvent, with liabilities exceeding assets by about $200,000.

Stern normally borrowed large sums of money to finance its operations. In March, 1924, the company approached Ultramares, a lending corporation, to borrow money. Based on the information contained in Stern’s audited balance sheet and certificate, Ultramares granted Stern three loans, for $100,000, $25,000, and $40,000, in December of 1924. Soon thereafter, on January 2, 1925, Fred Stern and Company declared bankruptcy. In November of 1926, Ultramares Corporation brought suit against Touche, Niven, and Company to recover the losses from the uncollectible loans. The company sued on the grounds of negligence and fraudulent misrepresentation.

The balance sheet audited by Touche showed approximately $1,350,000 of accounts receivable, of which more than $700,000 was fictitious. These fictitious receivables were recorded in Stern’s books by a late entry on February 3, 1924, made by a Stern employee. The auditors accepted the adjustment and did not perform tests on the fictitious receivables. If they had, they would likely have discovered the fraud. Other suspicious discrepancies also existed in the balance sheet. For example, the auditors discovered mistakes totaling $303,863 in Stern’s inventory account, which was originally reported at $347,219.

The Ultramares case made its way through three courts. The initial court hearing was a trial by jury that resulted in a ruling in favor of Ultramares Corporation on both counts, of negligence and of fraud. On appeal, the Lower New York Court of Appeals ruled again that negligence had occurred, but it found no fraud. The court based its decision on the 1922 case of Glanzer v. Shepard. The Glanzer decision stated that if a service was rendered primarily for the benefit of a third party, a company is potentially liable to the third party. Furthermore, the court stated that negligence, no matter how gross, was not equivalent to fraud.

The Upper Court of Appeals reversed the lower court opinion. It made an important distinction between the Glanzer and Ultramares cases: The service provided by Touche was primarily for the benefit of Fred Stern and Company, not a third party. For a third party to collect based on ordinary negligence, it must be a primary beneficiary, one that the auditor had been informed about prior to conducting the audit. If so, then there is “privity of contract” between the two parties.

Chief JusticeBenjamin N. Cardozo wrote about privity that “if there has been neither reckless misstatement nor insincere profession of an opinion, but only honest blunder, the ensuing liability for negligence is one that is bounded by the contract, and is to be enforced between the parties by whom the contract is made.” He stated that if accountants were liable for ordinary negligence, then “a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.”

The court went on to say that this finding did not free Touche from the consequences of fraud. Cardozo stated that negligence, when considered gross or extreme, can be construed to be equivalent to fraud, even though there is no intent to deceive or to do harm. The court believed that gross negligence existed in the Ultramares case, because by “certifying to the correspondence between balance sheet and accounts the defendants made a statement as true to their knowledge, when they had . . . no knowledge on the subject.” As a result of the court’s finding, Cardozo ordered that a new trial be granted to Ultramares concerning fraudulent misrepresentation.

Significance

The 1931 Ultramares case brought to the forefront the issue of auditor liability to third parties. Liability can extend to include both “known” and “unknown” third-party users depending on the type of negligence. In recent years, some courts have broadened the Ultramares doctrine to include recovery for ordinary negligence by “unknown” third-party beneficiaries. The Restatement of Torts, an authoritative compendium of legal principles, allows recovery by a reasonably limited and identifiable group whose members rely on the auditor’s work, known as “foreseen” users. The Credit Alliance court case (1985) further extended liability to “foreseeable” users. Under this concept, users that the auditor should have been able to foresee have the same rights as those in privity of contract.

As a result of Ultramares and other legal cases, accountants have become increasingly vulnerable to litigation. If an audited business experiences financial difficulties, and if a plaintiff can prove reliance on financial statements, the auditor may be subject to legal action no matter how professionally he or she conducted the audit. Investors and creditors with monetary losses sometimes have difficulty distinguishing between audit failure and business failure. Unable to recover money from a bankrupt business, they turn to auditors for compensation.

The cost of defending against such litigation has become extremely high. As a result, many accountants will settle out of court even if not guilty. In order to counter potential litigation, the accounting profession responded by setting up auditing standards and a code of professional conduct. The first authoritative auditing pronouncement, issued in 1917, was described as a “memorandum on balance sheet audits” and was intended to promote “a uniform system of accounting.” At the time of the Ultramares case, audit work was preformed primarily to assure the owner that the accounting within his or her business had been handled properly. The Ultramares court ruling, however, extended liability beyond that of the owner. Furthermore, in the late 1920’s, operating performance and net income became equally as important as the balance sheet. As the complexity and scope of business changed, the auditor’s role shifted from certifying the correctness of the balance sheet to reviewing the accounting system and gathering evidence to render an opinion on the fair presentation of financial statements.

A 1936 bulletin, “Examination of Financial Statements by Independent Public Accountants,” changed the accountant’s role from simple verification of the balance sheet to examination of the financial statements as a whole. Auditing standards concerning the auditor’s new role began to be issued. In 1947, the national professional accounting organization, the American Institute of Certified Public Accountants (AICPA), released its ten “generally accepted auditing standards” (GAAS). These represented general guidelines to aid auditors in fulfilling their professional audit responsibilities. The ten GAAS were divided into three categories: general standards, standards of fieldwork, and standards of reporting. With a few minimal changes, these standards continued to govern auditors’ work into the twenty-first century.

In brief, the general standards require auditors to be trained and proficient, to be independent in mental attitude, and to exercise due professional care. The standards of fieldwork require audit planning, the study of internal control, and the gathering of evidence. The reporting standards provide guidelines on matters to be addressed in the audit report. This discussion must include the client’s conformity with and consistent application of generally accepted accounting principles, full disclosure, and the rendering of an audit opinion.

As the number of third-party users of financial statements increased, the AICPA adopted its Code of Professional Ethics in 1973 to give further guidance regarding professional conduct. Certified public accountants were to conduct their affairs in a manner meriting public trust. The code of conduct consisted of general statements of ideal conduct and specific rules of unacceptable behavior. The code included discussion concerning topics such as independence, integrity and objectivity, and compliance with standards and principles. The code, now called the Accountant’s Code of Professional Conduct, was revised in 1988.

In further response to an increasingly litigious society, the AICPA updated the auditor reports in 1988 to define more clearly the roles of the auditor and management in the audit. Furthermore, at the beginning of an audit, accountants provide engagement letters to their clients that clearly outline the nature of the audit, the client’s responsibilities for the financial statements, and the meaning of the auditor’s report. Generally, accountants carry liability insurance to provide for payment of court defenses and claims. In addition, as another way of maintaining high quality within the accounting profession, the AICPA and some states require all public accounting firms providing attestation services to participate in periodic quality control reviews.

Ultramares was the first of many legal cases that affected the accounting profession and its development. As a result of the ruling in that case, auditors began to take a defensive approach when conducting audits. They became aware of the potential risk of litigation, and organizations of accounting professionals began working to maintain high standards for their members’ conduct.

Bibliography

American Institute of Certified Public Accountants Staff. AICPA Professional Standards. Chicago: Commerce Clearing House, 1992. Volume B contains the Accountant’s Code of Professional Conduct.

Cook, John W., and Gary M. Winkle. Auditing. 4th ed. Boston: Houghton Mifflin, 1988. Well-written textbook on auditing principles. Chapter on legal liability provides both historical and more current perspectives on the impacts of legal cases and government regulation on the auditing profession.

Guy, Dan M., and D. R. Carmichael. Wiley’s Student GAAS Guide. 2d ed. New York: John Wiley & Sons, 2000. A presentation of the AICPA’s standards for auditing aimed at accounting students.

Hubbard, Thomas D., et al. Readings and Cases in Auditing. 6th ed. Houston: Dame, 1989. Collection of writings explaining and critiquing the auditing profession.

Nielsen, Oswald. Cases in Auditing. Homewood, Ill.: R. D. Irwin, 1965. Contains legal opinions from all major court cases affecting the auditing profession.

Strawser, Jerry R., and Robert H. Strawser. Auditing: Theory and Practice. 9th ed. Houston: Dame, 2001. College textbook includes excerpts from newspaper and journal articles relating to developments in the accounting profession.